Tuesday, March 30, 2010

Last week's Adjustment Thinking and Salvation Syndrome post outlined some of the basic objectives of adjusting option positions. The two primary objectives were locking in gains or lowering the overall position cost and reducing or shifting risk. Since stock prices rarely move straight up or down in an orderly manner, those who maintain flexibility in their approach have an edge in producing long term profitability. As an aside, though the last sentence reflects the conventional wisdom I've subscribed to, the bullish run experienced over the last year certainly makes me give buy and hold a second thought.

Let's explore one such adjustment idea using call options on MEE (Massey Energy Corp). Suppose you decided to take advantage of the pullback that occurred in MEE from March 18-22 by purchasing a May 50 call for $4.00 on March 23rd. The net debit and max risk would be $4, the max reward unlimited, and the expiration break even $54.

As of yesterday, MEE had rallied roughly 8% and the call had increased in value to $6.70. Rather than selling the call option to capture the $2.70 gain, we may have considered rolling to a call spread by selling the May 55 call for $4.00. Since the premium received from the short May 55 call was sufficient to pay for the long May 50 call, our net debit and max risk was reduced from $4 to zero. The upside profit potential is also now capped at $500.

By rolling our long call position to a call spread we've succeeded in lowering the overall position cost and reducing the risk. Due to the large rise in MEE stock, we were able to completely eliminate the potential risk in the trade. Keep in mind this will not always be the case. Oftentimes you'll be selling the higher strike call for less than what you purchased the original call. In the case of MEE, suppose we sold May 55 call for $3 instead of $4. Instead of reducing the risk from $4 to zero, it would have been reduced from $4 to $1.

Being able to roll a profitable long call to a small or no risk call spread assumes you first have the ability to turn a profit with a simple long call option- a feat easier said than done. If you are a trader that purchases straight call options from time to time, it may be worthwhile to consider adding the adjustment to a call spread into your trading plan.

Monday, March 29, 2010

Hey Tyler. I purchased a July 240-250 call spread (bull call spread) for $4.80 on March 9th when PCLN was right around 240. After PCLN rallied to $262, the short 250 call was $12 in-the-money. Rather than waiting closer to expiration to realize more profit, we decided to exit early to avoid being assigned. Even though PCLN rallied $12 above our call spread, we only made about $180. Could you give me your insight on what we did wrong or missed in the trade? Also, with so much time value left in the trade, what is your opinion on early assignment?

Thanks, Kevin-

For the call spread to reach maximum profit potential, it must lose all of its extrinsic (time) value. For this to occur 4 months prior to expiration (as we stand right now), the calls have to move deep enough ITM to lose all of their extrinsic value. When an ITM option loses all its extrinsic value and is trading at its intrinsic value, we say it’s trading “at parity”. You can consult a risk graph to assess how high PCLN would have to move before expiration for you to capture the majority of your profit. Given that you used July options which still have 4 months to expiry, PCLN would probably have to move up toward 290 for the call spread to be anywhere close to its max profit at this stage in the game.

The other scenario which would cause the call spread to lose its extrinsic value is time decay. As a slightly ITM call spread approaches expiration it will increase in value bit by bit as extrinsic value whittles away. This is due primarily to the fact that the short call option possesses more extrinsic value than the long call option making the spread positive theta. When choosing to use call spreads, one must be aware that they perform more like position trades and take time to mature. For the impatient not wanting or willing to wait too long, you may consider using shorter term options. Though this doesn’t provide as much time for the stock to move above the higher strike of the spread, it does produce quicker results if you are indeed right.

As far as early assignment goes, you would not have been assigned this early in the game and even if you were it’s to your benefit, not detriment. Keep in mind when an option owner exercises, they lose any remaining extrinsic value in the option. Thus, if there was still $4 or $5 of extrinsic value in the 250 call option, they would be better off selling it as opposed to exercising. For illustrative purposes, let’s say you were assigned and obligated to sell 100 shares of stock at $250. Again, this isn’t necessarily a bad thing. You still own the 240 call and thus have the right to buy 100 shares at $240. If you exercised that right, bought 100 shares at $240 and sold them at $250, you would net $10. Since you entered the trade at $4.80, you would essentially be capturing your $5.20 of profit. And the beauty of it is you realized it in March instead of having to wait until July.

So did you make any mistakes? The answer really depends on what you were trying to achieve. If you were satisfied with the profit and had planned on exiting after a decent sized gain, then I’d say you did ok. On the other hand, if you were shaken out early because of fears of early assignment, I’d say perhaps you did make a mistake. As outlined, those fears are unfounded.

Tuesday, March 23, 2010

One of more prevalent ways many novice traders cut their teeth learning options is purchasing call and put options. While buying a directional call or put can provide large profits when right, they can be downright painful when wrong. It's rare to find traders who can rake in consistent profits when buying options is the only weapon in their arsenal. One would certainly have to be adept at forecasting a stock's price direction; a feat much easier said than done. When attempting the occasional long option trade, I've found increased success when using various adjustment techniques. Adjustment thinking in general helps with adapting to changing market conditions. The two primary objectives of adjusting are locking in gains and reducing or shifting risk.

When entering the realm of adjustment thinking one must be careful to avoid what I call salvation syndrome. This insidious disease can potentially rack up trading costs and compound losses. It's primarily characterized by traders who are constantly adjusting losing trades in an attempt to salvage some type of gain. They've got a bad case of the fix-its and rather than just exiting when trades go awry and moving to greener pastures, they attempt continual adjustments which often compound their problems. Consider the following example:

Suppose you sell an April 55-50 put spread on a $60 stock you deem bullish and expect to rise over the coming month. After 2 weeks of lackluster price action, the stock falls to $55 threatening to breach the higher strike of your put spread. Not wanting to lock in a loss, you decide to roll the put spread down and out to a May 50-45 put spread in an effort to make money back if the stock stabilizes or rallies. After making this adjustment, the Trading Gods unfortunately decide you need a better appreciation of Murphy's Law and therefore proceed to take the stock lower. As the stock approaches $50, you once again decide to "salvage" the trade by rolling to a June 45-40 put spread. Sensing that you're failing to learn the lessons, the infamous Trading Gods once again knock the stock down. Rinse and repeat...

In this example your adjustments merely served as salt to the wound, insult to injury, a compounding of your losses. Sometimes the best course of action is to simply exit. Let's be clear- there is nothing wrong with adjustments when used properly; there is something wrong when used improperly. I'll review a few such proper examples in subsequent posts.

Monday, March 22, 2010

Wednesday, March 17, 2010

March VIX options expired today with a settlement price of 16.68. Though the fear index gave a valiant effort in trying to remain elevated long enough for the naked put play mentioned in last week's Fading Complacency post to come out profitable, the incredibly low realized vol of the market won out in the end. With both 10 and 21 day historical volatility sub 10% on the SPX index and continuing to decline, it was simply a matter of time before the VIX caved in and became more in line with the day to day movements of the market.

We mentioned shorting the March 18 put for $.50. This placed the expiration break even for the trade at $17.50. With the settlement price coming in at $16.68, the trade would have lost $.82 had you held to expiration. If you exited early you could have easily locked in some type of profit or at least broke even. At one point over the last week the puts were trading at $.20. Within my own account, I ended up just buying them back yesterday at $.50 to break even.

This month's settlement illustrates why I don't usually hold these naked put plays into expiration. With the overnight gaps that can occur in the SPX and settlement being calculated off of the opening prices, you never really know what you're going to get. Tack on the fact that the naked puts weren't even profitable the day before expiration and you really don't have much of a reason to take the gamble of holding.

Monday, March 15, 2010

During Friday night's Options Action, a review of GS brought up discussion of stock replacement strategies. As traders we're constantly faced with the decision of when to take profits. Suppose we purchased 100 shares of GS last month when it was around $150. Over the past few weeks, GS has experienced a nice 15% rise in its stock price to $175. One dilemma facing us at present is whether or not we should take some money off the table. From a purely emotional standpoint, greed is tempting us to stay the course in the hope of garnering additional profits while fear is tempting us to jump ship to avoid giving back any gains. One potential method of compromise would be to enter a stock replacement strategy. The underlying rationale for entering the replacement is lowering your downside risk, while maintaining exposure to further gains if GS continues to rise.

The suggestion was to replace the long stock position with an April 180-190 vertical call spread (often referred to as a bull call spread or buying a call spread). Consider the risk graph:

By purchasing the call spread for $280, we've drastically reduced the risk as well as capital tied up in the trade. In addition, we've also succeeded in maintaining upside exposure if GS continues to rise over the next month. In replacing the long stock trade with this call spread, the trader must obviously be willing to limit any additional upside to $720. Considering owning 100 shares of GS at $150 ties up $15K, dropping the capital requirement to $280 is worth limiting the profit potential in my opinion.

Stock replacement strategies highlight many of the advantages of using options to supplement a stock trader's game plan.

Friday, March 12, 2010

When it comes to trading platforms, I get as giddy as the next guy when exploring new innovative features. My curiosity perks up every time I receive word of a new release looming on the horizon for the platforms I use in my own trading. Though there are no doubt numerous ways to slice and dice data, I appreciate the few times the programming gurus behind the scenes come up with a more efficient way to display pertinent information. I was therefore pleasantly surprised when Livevol Pro's newest build included a whiz bang 3D tool on volatility skew.

As long time option traders know, each option strike trades at its own implied volatility. The beauty of the 3D vol skew chart is the ability it gives users to compare volatility across different strikes and expiration months. This aids in selecting which options to use when structuring various strategies. Because the skew charts are in 3D, users have the ability to view them from different vantage points to get a better idea of their depth. Wanting to go for the gold, they also added the ability to view a playback of how vol skew has evolved over time. Watching the progression of volatility helps in identifying and better understanding the typical volatility build that occurs prior to important events such as earnings or FDA announcements, as well as the severe volatility crush that occurs following the catalyst.

Monday, March 8, 2010

With the recent upsurge in equities, volatility as measured by the VIX (formally called the CBOE Volatility Index), has gotten utterly clobbered. With 21 day historical volatility of the SPX sitting at a measly 11%, it could certainly be argued that the heavy VIX is justified. After all, nobody like's buying options at 20% volatility on a stock that's only realizing 10%. In hindsight it's easy to see that the early Feb VIX super spike to 29 was overdone. Boy has that inflated volatility bubble fizzled fast. The important question at hand is whether or not the pendulum has swung too far in the other direction? Has excess fear turned into too much complacency? Well, it's fair to say the VIX is oversold by just about any measure (proximity to moving averages, overstretched date & range, etc...).

As is customary with this time in the expiration cycle where expiration be comin' round the mountain, let's see if there are any plays worth considering. While the cash VIX closed the day at 17.79, March VIX futures are a tad higher at 18.35. Remember, March VIX options are priced based off March Futures, not the cash. As such, the 18 strike put option is out-of-the money, not in-the-money. If we wanted to fade the complacency we may consider selling the 18 strike put for $.50. While it would be nice to receive more premium, with a mere 7 trading days remaining before expiration (VIX options last trading day is next Tuesday), it's tough to find much premium remaining.

Thursday, March 4, 2010

How bout that MDVN... Wowza! If that doesn't give volatility sellers the heebie jeebies I don't know what will. That type of monster gap is the exact reason why selling naked strangles in front of a huge event is often considered crazy talk. It also supports the notion that options can indeed be a buy at 250% + volatility levels. I suppose it's a good thing I'm not a betting man because my volatility fade mentioned in the last post would have gotten absolutely smoked.

Ahhhh... the safety of the sidelines.

Let this serve as a lesson to any of you newcomers to the options arena that volatility gets bid up in biotech stocks for a very good reason (click to enlarge).

Tuesday, March 2, 2010

One of the more common methods of volatility analysis used by option traders is that of comparing historical volatility to implied volatility. The efficacy of this approach hinges on whether or not the past can be a good predictor of the future. In other words, can a stock's price behavior over the last 30 days be a good indicator of its behavior over the next 30 days? If you think it may, you're probably a proponent of this form of analysis. The biggest fly in the ointment however, is the fact that there are often events looming on the horizon, such as earnings or FDA announcements, that will drastically influence a stock's volatility. While these have no influence whatsoever on historical volatility, they will surely cause some noise with implied volatility.

In anticipation of these known events implied volatility will almost always be trading at elevated levels compared to historical volatility. This does not automatically make options a slam dunk sell. Take the current case of Medivation (MDVN). Though its 20 day historical volatility sits at a mere 40%, implied volatility has risen to an astronomical 260% (click to enlarge).

[Source: Livevol Pro]

Though the casual observer may suspect the options are a raging sell, there's more to this outrageous bid-up than meets the eye. As with most biotechs, MDVN has a blockbuster drug currently being tested which represents a potential windfall profit generator if approved. Due to the huge ramifications of this study, its results could cause the stock to swiftly double or halve. Just as with most binary events, options get bid up to extremely pricey levels beforehand.

We're I betting man I'd probably fade the volatility spike with a limited risk short vol strategy like a condor. Though there's enough juice in the OTM puts all the way down to the 15 strike, the upside calls top out at 75.

With setups like these I prefer to park myself in the safest spot in the lot... the sidelines.

Disclaimer

All content on this site is provided for informational and educational purposes. Furthermore, information contained herein reflects the opinions of its author and is provided for discussion purposes only. Under no circumstances does this information represent a recommendation to buy or sell securities, nor should it be construed as investment advice. Although the material is deemed to be accurate and reliable, I don't make any representations as to its accuracy, as a result there is no guarantee it is not without errors. I may or may not have positions in some of the names I mention.